Your SlideShare is downloading. ×
   Crisis caused by wide-spread default in home    loan repayment by sub-prime borrowers   Onset - 2007
   Large number of financial institutions    including the biggest names brought to the    edge of bankruptcy   Some big...
   The year – 2001   The situation – The dot com bubble had burst   Imminent recession   Government and Central Banks ...
   The Federal Reserve flooded the market with    liquidity   Banks awash with cash in reserves   Tremendous potential ...
   Expand home loan activity   Pyramid on newly enhanced cash base   Made possible by Fractional Reserve Banking
   Bank Reserve Ratio = 10%   Federal Reserve’s Reserve Ratio = 35%         Assets                LiabilitiesIOUs       ...
   MBS – Mortgage Backed Security
   The lien that a bank gets against a loan made   Borrower agrees to repay as per certain terms   In the event of defa...
   Collateral for lender   Reduces risk of loss of capital in the event of    default
   A financial instrument   Promises a certain stream of future cash    flows in exchange for a one-time payment    now ...
   Some underlying asset backs the security     Bond – The borrower     Stocks – The business and its assets   Future ...
   A security whose underlying asset is a    mortgage or a bundle of mortgages   Seller of security gets money today    ...
   Bank B lends money to A1 to An against home    mortgage   C buys bundle of mortgages from B at a    discount   C pri...
   Obvious reason 1 – Risk shifted to C or Di   Obvious reason 2 – B gets commission for    collecting repayments on beh...
   Cash in hand (original) - $1 M   Mortgage assets on Balance Sheet - $29 M   Discount = 6%   Price of mortgage asset...
   Getting a good price for the MBS
   MBS issuer guarantees security     Promises to make good in event of default   Gets security rated AAA by rating age...
   E offers to “insure” the MBS   Offers to “swap” cash flow streams   Tells D “Pay me $XX every year. If default    oc...
   Market for MBS highly liquid   Easy to buy and sell MBS   Even easier to create new MBS and sell them    at a good p...
   Creditworthy borrowers limited in number   What next?   Sub-prime borrowers   But what about credit risk?   MBS he...
   Largest issuers of MBS – Fannie Mae and    Freddie Mac     Fannie Mae – Federal National Mortgage Authority      (FNM...
   CRA – A law that requires banks to make loans    to sub-prime borrowers     Compliance a prerequisite for new branch ...
   Bank gives out sub-prime loan   Securitising firm buys bundle of mortgages   Bundle of mortgages securitised and MBS...
   Credit injection for home buying boosts    demand for homes   Loans go as cash to home builders   Stimulates home bu...
   Demand exceeds supply   Illusion of ever-rising prices fuels massive    speculative buying   Further boosted by lax ...
   Dec 2004 – Federal Reserve senses    overheated market   Dec 2004 – Jan 2006 – Interest rate raised    from 1% to 5.2...
   Market flooded with new supply   Supply overtakes demand   The unthinkable happens – Home prices fall   Demand shri...
   Sub-prime borrowers unable to repay as    interest rates spike   Little scope for selling homes in a depressed    mar...
   Holders of MBS face defaults   Market for MBS sees pullback   Prices of MBS on balance sheets of firms fall     Mar...
   Obligation on issuers of CDS’s to make good    MBS holders against default   Huge counter party risk to CDS issuers
   Lending slows to a crawl   Bank and Financial Institution balance sheets    start melting   Shares start tumbling
   March 2008 – Bear Stearns falls   August 2008 – Lehman Brothers falls   September 2008 – All big banks on the verge ...
   Caused a serious and deep economic slowdown   Credit crunch led large number of firms to the    brink of bankruptcy a...
   Across sectors, sales and profitability    Downsizing  numbers of unemployed    Widespread bankruptcy => even mo...
   Infusion of large volumes of liquidity     Trillions of dollars in guarantees and bailouts     To encourage spending...
   Financial packages to     boost consumer spending     reduce the rate of foreclosure of loans   Rescue packages for...
   Stepped in to reaffirm faith in financial    institutions     Blanket guarantees   Fiscal stimulus packages of large...
   US economy “officially” out of a recession     NBER has announced that the recession ended in     June 2010   A lot ...
   Fresh risks – Commercial mortgages, credit    cards and student loans   Money supply greatly increased in the last   ...
   Greed of mortgage lenders     Predatory lending    Stupidity/Greed of borrowers   Fancy financial products   Ques...
   Lenders were doing business   Borrowers were taking what they could get   Securitising is a normal risk mitigation d...
   Fractional Reserve Banking     Without it, banks could not have created as big a     bubble as they did   Central Ba...
   More money created => More interest    income   Incentive to borrow more and lend even more     Happened from 2001-2...
   Controlled money supply and banks   Manipulate money supply through     open market operations     manipulating int...
The sub prime mortgage bubble and the financial crisis of 2008
The sub prime mortgage bubble and the financial crisis of 2008
The sub prime mortgage bubble and the financial crisis of 2008
The sub prime mortgage bubble and the financial crisis of 2008
The sub prime mortgage bubble and the financial crisis of 2008
Upcoming SlideShare
Loading in...5
×

The sub prime mortgage bubble and the financial crisis of 2008

689

Published on

0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total Views
689
On Slideshare
0
From Embeds
0
Number of Embeds
1
Actions
Shares
0
Downloads
0
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide
  • Point 1 – The US, UK, Euro Zone and Japan are officially in a recession. It is wrong to say that a recession is defined as “two consecutive quarters of shrinking GDP. An example is the US where the NBER (National Bureau of Economic Research), a non-profit body considered the final authority on identifying recessions, declared by end-November that the US recession had started in December 2007 based on a large number of parameters. Estimates of economists of the length of the recessionary period vary from 2-3 years to 8-10 years (Nouriel Roubini, Peter Schiff, Marc Faber, Richard Celente). Terms used – V-shaped / U-shaped / W-shaped / L-shaped recovery. Basically these refer to the shape of the GDP vs time graph.Point 2 - Banks are unwilling to lend and firms are finding it tough to get even working capital loansPoint 3 – A number of banks, thrifts, mortgage refinancers, insurance firms and other financial institutions have either declared bankruptcy or have been fully or partially taken over by the government. More major banks and other FIs expected to go follow suit. Excessive money creation is also posing a serious threat to the purchasing power of various currencies.Point 4 – While current unemployment levels are at around 6.5% and the actual number of people unemployed is comparable to the last major recession that occurred in 1981-82 (Called the Savings & Loans or S & L crisis). Some commentators also make comparisons to the situation during the Great Depression, though unemployment in that period was around 30% (by recently revised estimates).Point 5 – Governments have tried massive bailouts of consumers and producers, but these have had limited and short-term impact. Central Banks have tried infusing massive amounts of liquidity, but that has not stimulated the economy or eased the flow of credit. Rates of borrowing from Central Banks across the world and at unprecedented lows, but these have not got the respective economies moving.US Federal Reserve – 0 to 0.25 %ECB – 2%BoE – 1.5%Bank of China – 2.2%RBI – 4% on Reverse Repo and 5% on Repo
  • The US economy is driven by consumers. 2/3rd of GDP is consumption expenditure. Consumers in the US have for long been highly credit dependent and most had the habit of spending way beyond their means. When credit became scarce, they cut back on spending. Firms were running out of credit for operations and investment and were finding it difficult to survive and grow. To make matters worse, the liquidity pumped into the market since 2001 sent prices of inputs soaring raising costs of production, seriously eroding the profits many firms. This resulted in further depressing sales and pushing firms deeper into the redUnemployment (in terms of absolute number of unemployed people) in the US is now at a 27 year high at over 10 million – Last seen during the severe recession of 1981-82. Jobs report for November shows 533,000 jobs slashed for the month, the highest since December 1974 when the US was in a deep recession. 524,000 jobs slashed for the month of December
  • Point 1 - $168 billion stimulus package through tax refund cheques (in July and August) to try and stimulate spending – had a very temporary effect. “Hope Now” programme - seeks to bring borrowers and lenders together to restructure mortgages and reduce the rate of foreclosures - No success to speak of till-date.Point 2 - Taking over Fannie Mae and Freddie Mac when they were about to go under. Size of bailout plan – upto $200 billion by initial conservative estimates. $700 bn bailout package (TARP or Troubled Asset Relief Programme). Originally intended to take suspect assets off the firms’ balance sheets. Now reoriented to buy shares of banks suspected to be on the precipice. The Treasury has already injected $150 billion into 7 top banks under this scheme in exchange for preferred shares. Citibank is almost completely taken over by the Government. A $85 billion (and then an additional $30 billion) loan package to AIG to save it from bankruptcy. Various European governments have offered similar bailout packages to their banks, financial institutions and industry. UK took a majority stake in a number of banks based out of the UK. Swiss government took a majority stake in UBS to save it from insolvency. Point 3 – US and European offered blanket guarantees on inter-bank lending to stimulate the flow of credit. Estimated value of guarantees - $3 trillionPoint 4 – Obama has just proposed an over $1 trillion package including tax rebates and investment in infrastructure. China has already announced a $586 billion stimulus package comprising tax rebates and infrastructure spending.
  • Point 1 - $168 billion stimulus package through tax refund cheques (in July and August) to try and stimulate spending – had a very temporary effect. “Hope Now” programme - seeks to bring borrowers and lenders together to restructure mortgages and reduce the rate of foreclosures - No success to speak of till-date.Point 2 - Taking over Fannie Mae and Freddie Mac when they were about to go under. Size of bailout plan – upto $200 billion by initial conservative estimates. $700 bn bailout package (TARP or Troubled Asset Relief Programme). Originally intended to take suspect assets off the firms’ balance sheets. Now reoriented to buy shares of banks suspected to be on the precipice. The Treasury has already injected $150 billion into 7 top banks under this scheme in exchange for preferred shares. Citibank is almost completely taken over by the Government. A $85 billion (and then an additional $30 billion) loan package to AIG to save it from bankruptcy. Various European governments have offered similar bailout packages to their banks, financial institutions and industry. UK took a majority stake in a number of banks based out of the UK. Swiss government took a majority stake in UBS to save it from insolvency. Point 3 – US and European offered blanket guarantees on inter-bank lending to stimulate the flow of credit. Estimated value of guarantees - $3 trillionPoint 4 – Obama has just proposed an over $1 trillion package including tax rebates and investment in infrastructure. China has already announced a $586 billion stimulus package comprising tax rebates and infrastructure spending.
  • NBER or the National Bureau of Economic Research is a non-profit organisation consisting of around 25 economists. It has for many years been the final arbiter of the starting and ending dates of recessions. It is interesting to note that the NBER does not define a recession as 2 consecutive quarters of declining GDP.
  • Major economists of the Austrian School – Ludwig Von Mises, Friedrich Hayek, Murray Rothbard all predicted the monetary policies adopted by the major economies will logically result in such crises.
  • Point 1 – The smile is to say that the claim is fairly laughable. In reality, the term is self-contradictory.
  • From 2001 onwards, the US Federal Reserve kept its Target Rate as low as 1%. The target rate is the rate of interest for borrowing of reserves from the Federal Reserve. Banks borrow reserves in the form of Treasury Bills, sell them in the open market, use the cash to add to their reserves and pyramid on top of that to create lots more money out of thin air.“Leveraged” refers to the state of having made inordinately high borrowings to run ones operations. Many I-Banks were leveraged to the extent of 1:30. In simple terms, for every $1 of capital, they had taken $30 of loans and invested them in a variety of assets including MBS’s.
  • Point 1 – When the Federal Reserve buys treasury bills, it increases money supply and when it sells them, it reduces it. Taking an example, when the Federal Reserve buys $100 billion worth of Treasury Bills, it issues a check for $100 billion payable on itself (an act of fraud on its own). The bank takes the cheque straight back to the Federal Reserve which credits the bank ‘s account with itself to the tune of an additional $100 billion. Treating this as part of its reserves towards reserve ratio, the bank may then go on and pyramid loans of $1 trillion (assuming a Reserve Ratio of 10%) creating an equal amount of demand deposits out of thin air. The net money supply increases by $900 billion ($1 trillion - $ 100 billion)While in a similar manner, sale of securities of $100 billion should reduce the money supply by an amount of $900 billion. However, a little sleight of hand ensures that the money supply does not decrease. The Federal Reserve first buys $11.1 1(100/(1/R.R-1)) billion of Treasury Bills from the bank, which then goes on to pyramid on top of that to create new loans of $111.11 billion (held as liquid assets) against which it creates an equal amount of money. It then disposes of these liquid assets to other buyers (within and outside America) to collect $111.11 billion, which it now uses to buy Treasury Bills worth $111.11 billion from the Federal Reserve. Thus, the Federal Reserve and the banking system ensure that either way, money supply does not decrease.Point 2 – Reserves lent are clearly held as reserves on which the banks pyramid 1/Reserve Ratio*Borrowed reserves as new loans and create an equal amount of money (out of thin air) in the form of Demand Deposits.
  • Transcript of "The sub prime mortgage bubble and the financial crisis of 2008"

    1. 1.  Crisis caused by wide-spread default in home loan repayment by sub-prime borrowers Onset - 2007
    2. 2.  Large number of financial institutions including the biggest names brought to the edge of bankruptcy Some big firms collapsed Many were rescued Credit freeze followed by deep recession  Wide-spread business failure  Massive unemployment
    3. 3.  The year – 2001 The situation – The dot com bubble had burst Imminent recession Government and Central Banks trying to grapple with the situation
    4. 4.  The Federal Reserve flooded the market with liquidity Banks awash with cash in reserves Tremendous potential to profit by lending The target – Real estate
    5. 5.  Expand home loan activity Pyramid on newly enhanced cash base Made possible by Fractional Reserve Banking
    6. 6.  Bank Reserve Ratio = 10% Federal Reserve’s Reserve Ratio = 35% Assets LiabilitiesIOUs 29,000,000Cash at C.B. 1,000,000C.B. Credit 1,900,000 Deposits 29,000,000 IOU to C.B 1,900,000 Equity 500,000 Debt 500,000Total 30,900,000 Total 30,900,000
    7. 7.  MBS – Mortgage Backed Security
    8. 8.  The lien that a bank gets against a loan made Borrower agrees to repay as per certain terms In the event of default,  bank seizes asset  sells asset  recovers loan or as much as it can
    9. 9.  Collateral for lender Reduces risk of loss of capital in the event of default
    10. 10.  A financial instrument Promises a certain stream of future cash flows in exchange for a one-time payment now  e.g. 1 – Bonds promise principal with interest  e.g. 2 – Stocks promise dividends
    11. 11.  Some underlying asset backs the security  Bond – The borrower  Stocks – The business and its assets Future cash flow on account of the asset Asset said to back the security
    12. 12.  A security whose underlying asset is a mortgage or a bundle of mortgages Seller of security gets money today  Based on price of security Buyer of security gets first claim on repayments against mortgages
    13. 13.  Bank B lends money to A1 to An against home mortgage C buys bundle of mortgages from B at a discount C prints mMBS’s and sells them to D1 to Dm Process called securitisation
    14. 14.  Obvious reason 1 – Risk shifted to C or Di Obvious reason 2 – B gets commission for collecting repayments on behalf of C Not so obvious reason – B is a bank Cash reserves shoot up Far greater scope for fractional reserve banking
    15. 15.  Cash in hand (original) - $1 M Mortgage assets on Balance Sheet - $29 M Discount = 6% Price of mortgage assets = $27.26 M Cash in hand (final) – $28.26 M Lending possible now - $28.26 M * 29
    16. 16.  Getting a good price for the MBS
    17. 17.  MBS issuer guarantees security  Promises to make good in event of default Gets security rated AAA by rating agency  S&P, Moody’s, Fitch MBS gets top security rating => Lowest discount rate => Best price
    18. 18.  E offers to “insure” the MBS Offers to “swap” cash flow streams Tells D “Pay me $XX every year. If default occurs, I will make good your loss”
    19. 19.  Market for MBS highly liquid Easy to buy and sell MBS Even easier to create new MBS and sell them at a good price Explosion in mortgages and their securitisation
    20. 20.  Creditworthy borrowers limited in number What next? Sub-prime borrowers But what about credit risk? MBS helps dump risk on someone else Only requirement – AAA rating
    21. 21.  Largest issuers of MBS – Fannie Mae and Freddie Mac  Fannie Mae – Federal National Mortgage Authority (FNMA)  Freddie Mac - Federal Home Loan Mortgage Corporation (FHLMC) Both GSE’s Carry implicit guarantee of US government Hence AAA?
    22. 22.  CRA – A law that requires banks to make loans to sub-prime borrowers  Compliance a prerequisite for new branch approval and to borrow through Fed emergency window ECOA – A law that requires banks not to discriminate on race, sex, etc.  Banks getting sued and penalised for millions Giving Sub-Prime loans was anyway on the cards Securitisation only made it easier
    23. 23.  Bank gives out sub-prime loan Securitising firm buys bundle of mortgages Bundle of mortgages securitised and MBS sold If guaranteed, end of path but for further sale If not, CDS makes it “safe”
    24. 24.  Credit injection for home buying boosts demand for homes Loans go as cash to home builders Stimulates home building industry Goes berserk buying factors and building homes Supply takes time to hit market
    25. 25.  Demand exceeds supply Illusion of ever-rising prices fuels massive speculative buying Further boosted by lax lending, low interest rates and easy initial terms Explosion in demand Demand outstrips supply even more Further rise in home prices
    26. 26.  Dec 2004 – Federal Reserve senses overheated market Dec 2004 – Jan 2006 – Interest rate raised from 1% to 5.25% Demand for homes starts slackening
    27. 27.  Market flooded with new supply Supply overtakes demand The unthinkable happens – Home prices fall Demand shrinks Home prices fall further
    28. 28.  Sub-prime borrowers unable to repay as interest rates spike Little scope for selling homes in a depressed market Non-recourse nature of US mortgages Home owners walk away Lenders left holding the bag
    29. 29.  Holders of MBS face defaults Market for MBS sees pullback Prices of MBS on balance sheets of firms fall  Mark-to-market rule Market for MBS becomes illiquid No idea of proper price for MBS on balance sheets
    30. 30.  Obligation on issuers of CDS’s to make good MBS holders against default Huge counter party risk to CDS issuers
    31. 31.  Lending slows to a crawl Bank and Financial Institution balance sheets start melting Shares start tumbling
    32. 32.  March 2008 – Bear Stearns falls August 2008 – Lehman Brothers falls September 2008 – All big banks on the verge of failing Credit squeeze and serious financial crisis
    33. 33.  Caused a serious and deep economic slowdown Credit crunch led large number of firms to the brink of bankruptcy and beyond The health of financial system still under serious threat Unemployment at multi-decade highs Policy failing to stimulate the economy
    34. 34.  Across sectors, sales and profitability  Downsizing  numbers of unemployed  Widespread bankruptcy => even more people out of jobs
    35. 35.  Infusion of large volumes of liquidity  Trillions of dollars in guarantees and bailouts  To encourage spending and lending/borrowing Reduction of Reserve Ratios and key interest rates
    36. 36.  Financial packages to  boost consumer spending  reduce the rate of foreclosure of loans Rescue packages for banks, mortgage lenders and sundry financial institutions affected by this crisis  Fannie Mae / Freddie Mac  AIG, Citibank
    37. 37.  Stepped in to reaffirm faith in financial institutions  Blanket guarantees Fiscal stimulus packages of large magnitude  Obama’s $ 800 bn package incl tax rebates and investment in infrastructure  China’s $586 billion package for infrastructure
    38. 38.  US economy “officially” out of a recession  NBER has announced that the recession ended in June 2010 A lot of “deleveraging” left US national debt (not unfunded liabilities) is nearly $16 trillion The US government has been declaring a record budget deficit every year.
    39. 39.  Fresh risks – Commercial mortgages, credit cards and student loans Money supply greatly increased in the last year 6 years More expansionary monetary policy is expected from Governments across the world  Purported aim – to “stimulate” the economy  Tremendous inflationary potential
    40. 40.  Greed of mortgage lenders  Predatory lending  Stupidity/Greed of borrowers Fancy financial products Questionable performance of rating agencies Inadequate governmental regulation of banking and finance
    41. 41.  Lenders were doing business Borrowers were taking what they could get Securitising is a normal risk mitigation device Rating agencies misled by implicit guarantees Regulation that “forces” banks to make sub- prime loans
    42. 42.  Fractional Reserve Banking  Without it, banks could not have created as big a bubble as they did Central Banks  They released banks from the discipline of the market
    43. 43.  More money created => More interest income Incentive to borrow more and lend even more  Happened from 2001-2006 Tendency to become highly “leveraged” Inevitable dilution in lending norms – risky loans
    44. 44.  Controlled money supply and banks Manipulate money supply through  open market operations  manipulating interest rates Lend “reserves” to banks – Make bigger pyramiding possible, easy and cheap

    ×